Computers Suck-Or do They?

Posted by Jeff Carter
on December 13th, 2010

My last post excoriated the way computers, and the computerization of certain marketplaces have changed the tenor of the marketplace. The change has been bad for the best interest of the markets. Exchanges, and the traders that participate in the market are the caretakers of the marketplace. Currently, the garden needs a lot of weeding.

However, I don’t want my post to be misinterpreted as being 100% against electronic trading, or 100% against high frequency trading. I am not. However, I think that different markets trade very differently. It’s up to exchange personnel to understand the differences between marketplaces and apply technology and rules accordingly. If there is one thing we have learned with the internet is that one size doesn’t fit all.

The way electronic technology is being applied to thinly traded commodity markets will ruin them.

Eventually, there will be only a few electronic market makers. They will be trading with each other. The real end users of the market will go to privately negotiated contracts to hedge their risk. What the exchange will be left with is a giant circle jerk. We all know how that ends and how fun it is.

In thinly traded markets, we really need is a re-imagination of how the electronic marketplace can interact with the old fashioned open outcry market. Grab the best of both worlds and integrate them. It’s totally possible today with advances in technology. Instead, people continue to use electronic trading with the hammer and nail theory. The harder they pound, the quicker the nail goes in. Unfortunately in some cases they are driving a stake right through the heart of a market and killing it without even realizing it.

The facts of the trade in the hog are really clear. A 250 lot stop order moved the market 170 points. That is criminal for an orderly market. That stop set off a domino effect of other stops, other types of orders. This would never have happened in an open outcry pit.

The exchanges have a choice to make. Eventually, people will find a better way to hedge if they keep pounding on that nail. The industry will collapse on itself. If you don’t believe me, go check out the volume and open interest in the pork bellies. It was once the busiest and most heavily traded contracts in the industry.

HFT traders, and algo traders can be great for the marketplace. But the exchanges also need to realize that electronic trading didn’t cure the market from the nefarious pit traders of old. There are also nefarious HFT and algos out there that really don’t give two craps about the market and will cheat to make their next nickel. In the old days, we just wouldn’t trade with them. On the screen, no one has a choice. It’s up to the exchanges to police them. The exchanges don’t have the desire to do that today.

The powers in charge have plenty of time to figure this out. Unless a well heeled competitor figures it out first. Because there is plenty of room for one to ease into the void.

Addition

This is why I referenced the seat market at CME. That is the evidence there is in fact a giant circle jerk beginning to take place. The HFT guys already own seats-no reason to buy them. The big banks already own-no reason to buy them. The way technology is being applied to the smaller markets is killing the independent trader. Yesterday in Crain’s Chicago Business, CME CEO Craig Donohue said as much. “Our capabilities are really built around very, very liquid products that have very high rates of turnover velocity.”.

The disparity in prices between CME seats and other exchange seats (NYMEX, CBOT) can almost be purely explained by two phenomena. One is that the other exchange members sold out their rights when CME acquired them. The second is that if a firm wants to clear CME, it needs to hold at least 6 CME seats to do so. The value of seats is predicated purely on demand for clearing, and the fee differential between retail, leasee, and member rates.

UPDATE

Battle lines are being drawn. GETCO met with the SEC to talk about flash orders. Flash orders are a practice that ought to be eliminated, along with quote stuffing, and sniffer programs.

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